KASS: Starker exchange rules are ironclad

DEAR BENNY: I am interested in purchasing a property using a 1031 exchange and am wondering if that restricts my ability to take out a mortgage on that property at a later time? – Tania.

DEAR TANIA: A 1031 exchange – also known as a Starker exchange – allows you to swap one investment property for another and if you follow the statutory rules, you will defer (not avoid) payment of any capital gains tax.

One of the legal requirements is that all of the money you get from the sale of the first property, known as the “relinquished” property, must go into the obtaining of the new property, known as the “replacement” property. And the replacement property must be equal to or more expensive than the relinquished property.

But once you own the replacement property, you have the absolute right to obtain a loan and pull money out of that property. Since you already own the property, and since it is investment property, the lenders treat this as a refinance, and the interest rates will not be the same as for a first-time residential homebuyer.

The rules are ironclad, cast in stone. You cannot deviate an inch or the IRS may void the transaction and you will have to pay capital gains tax. I recall a case years ago where a taxpayer sold his investment property and got a proceeds check from the escrow (title) company. The taxpayer did not cash the check but then decided to do a Starker exchange. He returned the check to the escrow company. The IRS challenged the transaction, and the court agreed. Since the taxpayer had possession of the money – albeit in the form of a check – even for a few minutes, that defeated the section 1031 requirement that the taxpayer not have any access to the sales proceeds of the relinquished property.

You want to do this right; contact an attorney who has familiarity with – and actually has done – Starker exchanges.

DEAR BENNY: What is the difference between simple interest and compound interest? My mortgage loan merely states that I have to pay “eight (8) percent interest.” My loan is from a doctor’s retirement fund, and I believe I am being charged interest on interest. – Kerry.

DEAR KERRY: First, if you are financially able, I would immediately pay off your 8 percent loan and get a more favorable interest rate. You are dealing with what is known as a “hard money lender” – whom some people call “loan sharks.” I make no allegations against your lender because there is a need in this economy for such loans, but too many of those lenders take advantage of uneducated and low-income families.

Simple interest means it is calculated only on the amount of the principal loan. For example, if you borrowed $100,000 at 8 percent, assuming you did not pay down the loan, every year you will be charged $8,000. If you keep the loan for four years, you will have to pay $32,000 in interest ($8,000 x 4). The formula for calculating simple interest: simple interest = principal x interest rate x term of loan.

Compound interest, on the other hand, means that the interest is added to the principal and next year’s calculation is based on that new number. In our example, in the second year, the interest will be $8,640 ($108,000 x 8 percent) and at the end of the four years, you will have to pay $34,048.90. The formula: compound interest = total amount of principal and interest in future years less principal amount.

As you can clearly see, compounded interest will be considerably more expensive. Case law throughout the country makes it clear that unless your loan document specifically states you are paying “compounded interest,” the lender must calculate it as simple interest. And many state laws dealing with residential mortgages do not permit compounding.

Benny Kass is a practicing attorney in Washington, D.C. and in Maryland. He is not providing specific legal or financial advice to any reader. He wants readers to e-mail him, but cannot guarantee a personal response. He can be reached at: mailbag@kmklawyers.com.